Consider Two Firms,U and L,both with €50,000 in Assets

question 49

Essay

Consider two firms,U and L,both with €50,000 in assets.Firm U is unlevered,and firm L has €20,000 of debt that pays 8% interest.Firm U has 1,000 shares outstanding,while firm L has 600 shares outstanding.Mike owns 20% of firm L and believes that leverage works in his favor.Steve tells Mike that this is an illusion,and that with the possibility of borrowing on his own account at 8% interest,he can replicate Mike's payout from firm L.Given a level of operating income of €2,500,show the specific strategy that Mike has in mind.After seeing Steve's analysis,Mike tells Steve that while his analysis looks good on paper,Steve will never be able to borrow at 8%,but would have to pay a more realistic rate of 12%.If Mike is right,what will Steve's payout be?

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Definitions:

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